the pay ratio disclosure rule does not provide useful ... pay ratio disclosure rule does not provide...
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The Pay Ratio Disclosure Rule does not Provide Useful Information to Tackle the
Executive Overcompensation Problem
Huan Lou
Nothing seems to get U.S. corporations’ dander up like a threat to perks of their
chief executives. On September 18, 2013 the Securities and Exchange Commission (“SEC”)
published a proposal to add a chief-executive-officer-(“CEO”)-median-employee pay ratio to
Item 402 of Regulation S-K to implement § 953(b) of the Dodd-Frank Wall Street Reform and
Consumer Protection Act (“Dodd-Frank Act”)1. Currently almost all publicly held companies
have to publish their CEOs’ compensation packages and the underlying rationale under 17 C.F.R.
§ 229.402 (2011). Now, on top of that, the proposed pay ratio rule will require a registered
company2 disclose the median of annual total compensation of all employees (excluding the
CEO) of an issuer, the annual total compensation of that issuer’s CEO and the ratio of the two
amounts, which is referred as the “pay ratio3”. So far like a rock dropped in a lake, the proposed
amendment to Item 402 has invoked waves of reactions from institutional investors, lawyers, and
1 Pay Ratio Disclosure, 78 Fed. Reg. 60560 (proposed Sept. 18, 2013) (to be codified at 17 C.F.R.
pt. 229, 249).
2 Three types of listed companies are exempted from the pay ratio disclosure rule. They are
emerging growth companies defined in Jumpstart Our Business Startups Act § 102(a)(3),
smaller reporting companies that comply with a small scale set of disclosure rules set forth in
Items 402 (m)- (r), and foreign private issuers and MJDS filers. See id. at 16- 18.
3 Id.
2
CEOs and directors of public companies4. Investors, such as union pension funds, welcome the
new rule, which they plan to use to slow CEO pay increase while a voice from the SEC speaks
out the failure to discern any additional value brought by the pay ratio5.
This article is designed to discover the value that the pay ratio proposal brings to
investors, public companies and the society and the costs that it may incur. Part I of the article
starts with the existing CEO pay disclosure rule and the pay ratio proposal. Then it deciphers
how and by whom a CEO’s pay is decided. Part II summarizes how the pay ratio will impact
investors’ investment decisions and problems it may cause. Then assuming the pay ratio does
decrease a CEO’s compensation, the article talks about that the disclosure will bring about some
value and at the same time negative influence to a registrar and the labor market. At last the
article recommends the use of a company-profit-CEO’s-compensation ratio instead of the pay
ratio to measure the fairness of a CEO’s pay. Finally it concludes that the pay ratio leads to more
trouble than benefits to public company investors and the macro-economy and an alternative
ratio may be a better indicator on the fairness of a CEO’s pay with lower calculation cost to the
registrar.
4 Andrew Ackerman & Joann S. Lublin, SEC Wants Boss-Employee Pay Gap on Display, WALL
ST. J., Sept. 19, 2013, at C1. See generally Comments on Pay Ratio Disclosure,
http://www.sec.gov/comments/s7-07-13/s70713.shtml (showing that the SEC has collected
32,460 pieces of responses as of November 9, 2013 and the comment period of the proposal ends
on December 2, 2013).
5 “There are no- count them, zero-benefits that our staff have been able to discern,” said Daniel
Gallagher, a Republican member of the SEC. Id.
3
I. The CEO Compensation Regulatory Mechanism and Its Decision Making
Process
A. The Current CEO Pay Disclosure Regulations
The statutory monitor over a CEO’s pay can be traced back to 1938 when the SEC
promulgated its first executive and director compensation disclosure rules for proxy statements6.
The regulation has gone through several revolutionary revisions and matured to the current
version set forth in 17 C.F.R. § 229.402 (Aug. 12, 2011), which employs tabular and narrative
method to describe the compensation packages as accurately and concisely as possible7. The
SEC requires a public company identify its CEO’s total pay, salary, bonus, stock awards, option
awards, non-equity incentive plan compensation, change in pension value and nonqualified
deferred compensation earnings, and others in the Summary Compensation Table8. Specifically,
a registrar has to disclose the components for option awards and stock awards, such as number
6 3 Fed. Reg. 1991 (Securities and Exchange Comm’n Aug. 11, 1938).
7 At different times, the SEC has adopted rules mandating narrative, tabular, or combinations of
narrative and tabular disclosure as the best method for presenting compensation disclosure in a
manner that is clear and useful to investors. See, e.g., Release No. 34-3347 (Dec. 18, 1942),
Release No. 34-4775 (Dec. 11, 1952), Release No. 33-6003 (Dec. 4, 1978), Release No. 33-
6486 (Sept. 23, 1983), Release No. 33-6962 (Oct. 16, 1992), Release No. 33-7032 (Nov. 22,
1993). Executive Compensation and Related Person Disclosure, 71 Fed. Reg. 78338, at 10 fn. 46
(Securities and Exchange Comm’n Dec. 22, 2006).
8 Regulation S-K, 17 C.F.R. §229.402 (a)(5)(2011).
4
and market value of securities unexercised, number and market value of shares not vested9.
Bearing the spirit of lightening the compliance burden, the Item 402 of 2011 forfeits the
disclosure of a CEO’s any personal benefits or property worth less than $ 10,00010
. In response
to the public outcry toward an unsuccessful CEO’s unduly fat paycheck, the 2011 regulation
demands a narrative description of the change-in-control arrangement (or the “golden parachute”
provision)11
, including the triggering circumstances, payments in each covered circumstance, and
the rationales behind12
. Even more, the shareholders have been empowered by Congress to vote
on the executive payments for a frequency not less than three years since July, 201213
. This “say-
9 Id. (f)(1). See also Charles M. Yablon, Bonus Questions- Executive Compensation in the Era of
Pay for Performance, 75 NOTRE DAME L. REV. 271, 293 (1999) (endorsing that current SEC
disclosure rules succeeded fairly well in providing detailed information concerning the
compensation practices of publicly traded firms though the severance pay problem was left out at
that time).
10 Id. (i)(2)& (3).
11 Disclosure of Executive Compensation, 48 Fed. Reg. 44467-02, at 6 (Securities and Exchange
Comm’n Sept. 29, 1983).
12 Regulation S-K, 17 C.F.R. §229.402 (j) (2011).
13 15 U.S.C. § 78 n-1 (2012) (stating that “[n]ot less frequently than once every 3 years, a proxy
or consent or authorization for an annual or other meeting of the shareholders for which the
proxy solicitation rules of the Commission require compensation disclosure shall include a
separate resolution subject to shareholder vote to approve the compensation of executives, as
disclosed pursuant to section 229.402 of title 17, Code of Federal Regulations, or any successor
thereto.”).
5
on-pay” provision gives shareholders direct power to deny a compensation package or a golden
parachute agreement14
. Though it appears to impose high pressure on the compensation decision
makers, the results of voting showed that more than 98% of companies in Russell 3000 received
a favorable vote on their SOP proposal in 201115
.
B. The Pay Ratio Proposal
The Congress conceives that the current CEO compensation disclosure rule insufficient
to solve the oversized remuneration problem. Therefore it promulgates § 953 (b) in Dodd-Frank
Act, of which the unclear legislative intent offers little help in interpreting the statutory
disclosure requirement16
. In the proposal, the SEC wants the “median of the total compensation
of all employees” available to the public17
. First, the SEC explains that “all employees” mean all
14
SEC Release, SEC Adopts Rules for Say-on-Pay and Golden Parachute Compensation as
Required Under Dodd-Frank Act, (Jan. 25, 2011) http://www.sec.gov/news/press/2011/2011-
25.htm. See also Blake H. Crawford, Eliminating the Executive Overcompensation Problem:
How the SEC and Congress Have Failed and Why the Shareholders Can Prevail, 2 J. Bus.
Entrepreneurship & L. 273, 305 (2008).
15 Mark A. Metz, Say What!? Results of the First Year of Mandatory Say on Pay in the United
States and Related Litigation, 12 J. BUS. & SEC. L. 281, 282-83 (2011).
16 The SEC, supra note 1, at 20.
17 The proposed amendment is written in the following language: the proposal would require the
disclosure of “(A) the median of the annual total compensation of all employees of the registrant,
except the principal executive officer of the registrant; (B) the annual total compensation of the
principal executive officer of the registrant; and (C) the ratio of the amount in (A) to the amount
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full-time, part-time, seasonal and temporary workers of the registrant or any of its subsidiaries,
including foreign subsidiaries as well18
. The inclusion of the registrant’s global work force
implicates the data privacy regulations of the European Union workers and the transfer of
payrolls and the pension and benefit processing19
. Second, with respect to “total compensation”,
the SEC would not permit certain compensation adjustments that ostensibly reflect a more
accurate picture of the human capital investment. The SEC explicitly disallows full-time
equivalent adjustments for part-time workers, annualizing adjustments for temporary and
seasonal employees, or cost-of-living adjustments for overseas employees. The SEC blindly
believes the costs of those adjustments are not justified though it admits the adjustments may
in (B), presented as a ratio in which the amount in (A) equals one or, alternatively, expressed
narratively in terms of the multiple that the amount in (B) bears to the amount in (A).” Id.
18 See Letters from American Bar Association; American Benefits Council; Brian Foely & Co.
and Senator Menendez, the sponsor of Section 953(b) (stating that “[s]pecifically, I want to
clarify that when I wrote ‘all’ employees of the issuer, I really did mean all employees of the
issuer. I intended that to mean both full-time and part-time employees, not just full-time
employees. I also intended that to mean all foreign employees of the company, not just U.S.
employees.”). See the Securities Act of 1933 Rule 405 and the Exchange Act of 1934 Rule 12b-2
for the definition of “significant subsidiary”, which is applied in this proposal as well.
19 European Union Directive on the Protection of Individuals with Regard to the Processing of
Personal Data and on the Free Movement of Such Data 95/46/EC, 1995 O.J.L. 281 ( setting forth
the regulatory framework governing the transfer of personal data from an EU Member State to a
non-EU country).
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cure the distortion of the pay gap20
. And the nonexecutive employees’ compensation is
calculated according to Item 402, which is designed specifically to evaluate a CEO’s pay.
Thirdly, the method of calculating the median of total compensation of all employees is not
prescribed in the proposal21
. The SEC permits the registrant to employ any reasonable manner,
such as sampling, that is cost-efficient based on the particular conditions of the registrant22
.
Regarding the median pay number, a registrar can calculate the ratio of its CEO’s
compensation and employees’ pay. Unfortunately neither the statute nor the legislative history
tells the intended benefits of the ratio23
. Supporting commenters speculate that the pay ratio-type
information will help investors understand how issuers distribute compensation dollars
throughout the firm in ways that may boost employees’ morale and productivity24
because they
20
The SEC, supra note 1, at 35.
21 Median is “a value in an ordered set of values below and above which there is an equal number
of values or which is the arithmetic mean of the two middle values if there is no one middle
number.” Here the median payment of all employees is a number that half of employees are paid
above and half below. Merriam-Webster Dictionary, http://www.merriam-
webster.com/dictionary/median (last visited Nov. 22, 2013).
22 Id. at 39.
23 Section 953 (b) originated in the Senate. It was first introduced in S. 3049, the “Corporate
Executive Accountability Act of 2010” and then appeared in S. 3217, the “Restoring American
Financial Stability Act of 2010.” The brief references to the pay ratio disclosure in the legislative
records all opposed to the provision. See the SEC, supra note 1, at 11.
24 The SEC, supra note 1, at 92. See also letter from Calvert Investment Management.
8
feel the CEO is on the same team with them with a relatively small pay disparity25
. Another
alleged benefit is that the pay ratio disclosure will promote social equality by making employees
and shareholders feel fair with a narrow pay gap. But conceiving the SEC a disclosure regulator
and investors’ protector, the minority of the Congress affirmatively insist that the SEC
concentrate on improving disclosure about the underlying assets to enable investors to conduct
due diligence26
. Those Congress members point out that though the pay ratio information appeals
to “popular notions that CEO salaries are too high”, it does not provide “material information to
investors who are trying to make a reasoned assessment of how executive compensation levels
are set27
.”
C. How a CEO’s Compensation Is Decided
Despite the disclosing requirement, the proposal does not suggest a healthy or desirable
ratio or a ratio range28
. To appreciate the pay ratio’s impacts on the CEO’s compensation, this
section offers a brief overview of factors that a company’s hiring authority takes into
consideration. A recruitment committee normally counts the company’s financial and operational
25
Linda J. Barris, The Overcompensation Problem: A Collective Approach to Controlling
Executive Pay, 68 Ind. L.J> 59, 71 (1992) (stating that an official of the Colgate-Palmolive
Company admitted that the biggest barrier to teamwork is executive pay).
26 S. REP. NO. 111-176, at 245 (2010).
27 Id.
28
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objectives when it sets the CEO compensation29
. Heavy weight is given to these factors, like
earnings before interest, taxes, depreciation and amortization (EBITDA), earnings per share
(EPS), product development, customer service, and etc30
. The company expects the CEO will
lead the company hit the set goals in the above areas. Moreover, firms hope to recruit top
executive talents and this competition inevitably raises pay levels31
.
Scholars have reduced the finance-based, performance-based and market competition
factors to formulas that directly reflect how these factors interact with each other and influence
the total pay number. The article uses v as a CEO’s outside options, y the value of the CEO’s
production to the firm, β the fraction rate of the CEO’s share in the total CEO work production
surplus and 1-β the fractional rate of the company’s surplus share32
. Then the CEO’s wage is wβ=
(1-β)v + βy and the company’s surplus is Sπ= (1-β) (y-v)33
. Based on the formulas, a CEO’s work
productivity y, the opportunity cost or outside option v, and the split ratio β theoretically set the
foundation of the compensation metric. Also Sπ= (1-β) (y-v) indicates that the market price for a
CEO v should not exceed the CEO’s production value.
29
See RiskMetrics Group, Explorations in Executive Compensation 13 (2008), available at
http://www.riskmetrics.com/sites/default/files/RMGExplorationsinExecutiveCompensation2008
0520Final.
pdf.
30 Omari Scott Simmons, Taking the Blue Pill: The Imponderable Impact of Executive
Compensation Reform, 62 S.M.U. L. Rev. 299, 311 (2009).
31 Id. at 312.
32 Pietro Garibaldi, Personnel Economics in Imperfect Labour Markets 2 (2006).
33 Id. at 5.
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y is measured by the additional revenue that CEO brings to the company, the CEO’s
marginal revenue product34
. One empirical survey reveals that thirty-five to sixty percent of the
firm performance can be attributed to the management35
while economic climate and the state of
industry count for ten to twenty percent and thirty to forty-five percent respectively36
. Therefore
CEOs that have bigger impact on the company value should be paid more37
. The second decisive
factor v represents the compensation that he could obtain from another employment opportunity
but forfeit it because of the current position. v is directly linked to the CEO market, which is not
robust and lacks transparency38
. The insufficient CEO market fails to cap CEO compensation
and therefore increases the possibility that v exceeds y. An insufficient market also enhances a
CEO’s bargaining power and influences β. A recruiter has to distribute a large portion of the firm
surpluses to a potential CEO to retain him39
.
D. Compensation Committees Decide CEOs’ Pay and Board Capture
34
Derek Bok, The Cost of Talent: How Executives and Professionals Are Paid and How It
Affects America 14-15 (1993).
35 The Curse of Charisma, Economist, Sept 7, 2002, at 58.
36 Rakesh Khurana, The Curse of the Superstar CEOP. Harv. Bus. Rev., Sept. 2002, at 60, 63.
37 Thomas, supra note, at 1201.
38 Simmons, supra note , at 314 (showing that “the number of candidates that a Fortune 500 firm
would consider in a CEO search would be few” and the selection process involves internal
politics and social pressure that often require “secrecy and confidentiality”).
39 Randall S. Thomas, Explaining the International CEO Pay Gap: Board Capture or Market
Driven?, 57 Vanderbilt L. Rev. 1171, 1224 (2004).
11
Compensation decisions at most public companies are made by independent
compensation committees due to § 952 of the Dodd-Frank Act and § 10C of the Securities
Exchange Act of 1934 (the “Exchange Act”). Under § 10C no company, subject to limited
exceptions, can be listed unless specific conditions are satisfied with respect to the authority of
the compensation committee, the independence of the members of the compensation committee,
and the consideration by the compensation committee of specific factors relating to the
independence of compensation advisers40
. Accordingly New York Stock Exchange (NYSE) and
Nasdaq Exchange set up their own standards of the independence of compensation committees41
.
For example, the NYSE directs its listed companies to consider the sources of the committee
members’42
compensation and the relationships of the members to the listed company43
. Unlike
40
See Lawrence R. Bard & Daniel R. Kahan, Stock Exchanges Submit Proposed Compensation
Committee and Adviser Independence Rule Changes to SEC, MORRISON FOESTER LLP (Oct. 3,
2012), http://www.mofo.com/files/Uploads/Images/121003-Stock-Exchanges-Submit-Proposed-
Changes-to-SEC.pdf.
41 Id.
Thereafter the NYSE promulgated its rule on the independence standard of compensation
committee members in the NYSE Listed Company Manual § 303A.02(a)(ii) and Nasdaq adopted
the new rule in NASDAQ Rule 5605(d)(2)(A). See Joseph E. Bachelder III, Exchange Rules on
Independence of Compensation Committee Members, MCCARTER & ENGLISH, LLP (May 9, 2013
9:30 AM), http://blogs.law.harvard.edu/corpgov/2013/05/09/exchange-rules-on-independence-
of-compensation-committee-members/.
42 The compensation committee consists of independent outside directors most times. See Metz,
supra note Error! Bookmark not defined., at 282.
12
the NYSE, the Nasdaq leaves no discretion to the board to determine whether the compensation
is sufficiently material to preclude a director from being independent as preclusion is automatic44
.
Despite of the stringent rules, there is still a structural weakness that renders
compensation committees passive in negotiating CEOs’ pay45
. Board Capture theorists may
explain that boards of directors and compensation committee members heat up the CEO’s market
by irrationally aligning with the CEO’s interest because they are or were executives at other
companies and they expect this CEO to do the same when he votes at board meetings for other
companies46
. A compensation committee is normally comprised of non-employee directors
handpicked by the CEO47
. They have little incentive and time48
to negotiate the pay package
43
Bachelder, supra note 41.
44 Id.
45 “Overcompensation is basically the fault of passive boards that agree to salary packages on
demand, without spirited negotiations.” See Adam Bryant, Some Second Thoughts on Options,
N.Y. Times, Sept. 21, 1997, § 3, at 1 (quoting Professor Charles Elson).
46 James D. Cox, The ALI, Institutionalization, and Disclosure: The Quest for the Outside
Director’s Spine, 61 Geo. Wash. L. Rev. 1233, 1243 (1993) (stating that “[T]he prevalent ethos
of nominating committees [is] to submit names believed acceptable to the CEO ...”); and Charles
M. Elson, The Duty of Care, Compensation and Stock Ownership, 63 U. Cin. L. Rev. 649, 651
(1995).
47 Thomas, supra note , at 1191.
48 “The committee meets several times a year and sometimes every time there is a board meeting.”
See GRAEF S. CRYSTAL, IN SEARCH OF EXCESS: THE OVERCOMPENSATION OF
AMERICAN EXECUTIVES 43 & 215 (1991).
13
against the CEO and expect that this CEO will not say “no” to their pay when sitting on their
own companies’ compensation committees49
. An empirical study reveals a correlation between
the compensation committee members’ payments and the CEO’s remuneration50
. “For every
increment of $100,000 in the average annual salary of the outside directors on the compensation
committee, the salary of the company’s CEO can be expected to rise $51,00051
.” Therefore the
CEO market is distorted due to the structural weakness of the CEO-controlled corporate
governance.
E. CEOs are Generally Considered Overpaid
49
Susan J. Stabile, One for A, Two for B, and Four Hundred for C: The Widening Gap in Pay
Between Executives and Rank and File Employees, 36 U. Mich. J.L. Reform 115, 129 (2002)
(stating that CEOs have stronger economic incentives to dominate the compensation negotiation
than boards or compensation committees do to resist domination).
50 James A. Cotton, Toward Fairness in Compensation of Management and Labor:
Compensation Ratios, a Proposal for Disclosure, 18 N. Ill. U. L. Rev. 157, 172 (1997).
51 The SEC and the Issue of Runaway Executive Pay: Hearings on S. 1198 Before the Subcomm.
on Oversight of Government Management, Comm. on Governmental Affairs, 102d Cong., 1st
Sess. 8 (1991) (statement of Graef S. Crystal, Adjunct Professor of Organizational Behavior and
Industrial Relations, University of California at Berkeley).
14
With 475 to 500 multiples of the average CEO compensation and the pay of average
employees52
, the current majority view is that CEOs are generally overpaid. Public is furious
about the average CEO of a S&P 500-Index company receiving $ 9.25 million in 2009 while
millions of workers losing their jobs and retirement savings53
. For instance, Aubrey McClendon,
CEO of Chesapeake Energy, took home $ 112.5 million in 2008. Meanwhile Chesapeake
Energy’s net income only reached $ 623 million, an almost fifty percent decline from the prior
year54
. Among S&P 500 firms55
, the average CEO compensation levels have climbed 146% from
52
SeeJennifer Reingold & Fred Jespersen, Executive Pay, Bus. WK., Apr. 17, 2000, at 110
(stating that in 1999, the average CEO earned 475 times the average wage of a blue collar
worker); AFLCIO, CEO Pay: Still Outrageous, at
http://www.aflcio.org/corporateamerica/paywatch/pay/ (last visited Dec. 19, 2002) (citing
Business Week to the effect that the average CEO made 531 times the average blue-collar's pay
in 2000, compared to a multiple of 85 in 1990).
53 James Parks, Don’t Let the Chamber and Big Biz Gut Worker’s Say on CEO Pay, AFL-CIO
Now Blog (Oct. 18, 2010), http://blog.aflcio.org2010/1O/18/dont-let-the-chamber-and-big-biz-
gut-workers-say-on-ceo-pay/.
54 Stuart Lazar, The Unreasonable Case for a Reasonable Compensation Standard in the Public
Company Context: Why It Is Unreasonable to Insist on Reasonableness, 59 Buff. L. Rev. 937,
938 (2011).
55 The S&P 500 companies capture approximately 80% coverage of available market
capitalization. S&P Dow Jones Indices, http://us.spindices.com/indices/equity/sp-500 (last
visited Nov. 13).
15
1993 to 200356
. But the firm size and performance can explain only 40% of the actual increase,
with 60% of the total increase remaining unexplained57
. It implies that v and β must have
increased to explain the 60% pay growth.
F. Investors Use Financial Ratios to Evaluate Corporation’s Performance
It has a long history that investors and boards of directors rely on financial ratios to make
business decisions, such as evaluating stock prices58
. A study made in 1912 identifies eight ratios
most useful in the analysis of company performance59
, which develop to the modern accepted
ratios, such as pre-tax profit margin, liquidity ratio, capitalization ratio, and net income to net
worth60
. Most, if not all, of the ratios focus on how well certain assets of the corporation can
produce revenue. For example the net income to net worth ratio shows how much the company is
earning on the shareholders’ investment, about which shareholders are obviously curious 61
. The
amount of a CEO’s compensation influences this ratio indirectly in a manner that the net income
56
Lucian Bebchuk & Yaniv Grinstein, The Growth of Executive Pay, 2 (2005).
57 Bebchuk & Grinstein, at 8.
58 See generally J. Edward Ketz, et al., A Cross-Industry Analysis of Financial Ratios:
Comparabilities and Corporate Performance 1 (1990).
59 Sister Isadore Brown,O.S.U., M.A., The Historical Development of the Use of Ratios in
Financial Statement Analysis 14-15 (1995).
60 James A. Cotton, Toward Fairness in Compensation of Management and Labor: Compensation
Ratios, A Proposal for Disclosure, 18 N. Ill. U.L. Rev. 157, 176 (1997).
61 Understanding Financial Statements, New York Stock Exchange, 1986-87, at 18.
16
decreases when CEO pay goes up. [This ratio may raise a red flag for shareholders when revenue
is climbing up but the ratio does not look proportionately good.]
II. The Pay Ratio does not Substantially Help Investors Restrain CEO’
Compensation and Promote Company Performance
A high pay ratio may warn a board of directors that they need think about the
fairness of the CEO pay but it does not evaluate CEO’s compensation based on core decisive
factors. This ratio does not provide material information with respect to compensation decisions
and investment decisions. In spite of the fact that the pay ratio does not necessarily lead to CEO
pay cuts, some companies may decrease executive pay if the number is too embarrassing. But
this productivity-unrelated deduction can artificially depress the U.S. CEO market and IPOs. The
ostensible usefulness of the ratio does not deny the need of compensation disclosure because of
the ugly reality of the overcompensation problem. This article proposes an alternative ratio: net
income/ CEO pay, which reflects whether a CEO produces the value that entitles him the
handsome payment.
A. The Pay Ratio does not Solve Some Controversial Problems, Such as the Lucrative
Golden Parachute Provision and Option Plans
The pay ratio disclosure is designed to respond to the public outcry of the lucrative pay
to CEOs when they are forced to resign due to their unsatisfying performance. Shareholders feel
it unfair to pay a CEO who fails to achieve the financial and operational goals, based on which
the compensation was set62
. But the pay ratio disclosure does not do a better job than current
Item 402, which has already covered the golden parachute in a separate table from the summary
62
See RiskMetrics Group, supra note 29.
17
compensation table63
. The pay ratio does nothing to scrutiny the reasonableness and fairness of a
strongly favoring CEO golden parachute provision. It does not make any effort to prevent the
replay of the Walt Disney’s golden parachute litigation, in which Disney Company’s
shareholders filed derivative lawsuits against the company’s board for giving the president Ovitz
$140 million for his slightly over one year work64
.
The pay ratio simply compares the a CEO’s pay and the median employee pay that are
computed based on the same standard set forth in Item 402(c)(2)(x)65
. Since Item 402(c)(2)(x)
leaves unsolved the option valuation, the pay ratio disclosure provides no further help on this
issue either and cannot forestall option-award-centered litigation. For example, Professional
Management Associates, Inc. entered a five-year compensation agreement with its CEO, who
would receive a bonus of 2.5% of the company’s pre-tax income, half of which was paid in cash
and the other in common stock of the company66
. The company made a lot of profits with the
63
17 C.F.R. § 229.402 (t).
64In 1995, Walt Disney Company hired as the president and second man, Michael Ovitz, who
secured a five-year employment contract with an acceleration provision in the event of
termination. Because Ovitz did not get along with the CEO Michael Eisner, Ovitz was dismissed
and based on the acceleration clause received benefits valued up to $ 140 million. Outraged
toward the payment, shareholders filed derivative lawsuits in California and Delaware courts for
breach of fiduciary duties. See Walt Disney, Co., Notice of Annual Meeting Stockholders 4
(1997).
65 The SEC, supra note 1, at 50.
66 Professional Management Associates, Inc. v. Coss, 574 N.W.2d 107, 109 (ct. of App. MN
1998).
18
CEO and therefore the CEO’s bonus reached astonishingly high numbers during the five years,
like $ 65.5 million in 1995 and $102.5 million in 199667
. Four institutional shareholders went
mad about the compensation and brought a derivative suit against the board for the alleged
corporate waste68
. Even if at that time the board of directors had referred to the CEO and median
employee pay ratio, they would not have known the CEO’s bonus would soar so much that
shareholders would feel it egregiously unfair.
The pay ratio cannot insulate the board or the compensation committee from
compensation law suits because it does not solve the lucrative golden parachute and option
valuation. Shareholders will sue the board for too much pay to an underperforming CEO based
on the golden parachute when the business plummets or they will sue based on undervaluing
option awards when the business soars.
B. The Pay Ratio does not Provide Material Information to the Investors
Not only cannot the pay ratio solve some controversies left from the current disclosure
regulation, but does not give useful information for investors to make business decisions or for a
board of directors to make compensation decisions. “The objectives of the firm are to benefit
shareholders by attracting capital, performing efficiently and profitably, and complying with the
law69
.” But the pay ratio does not tell shareholders how much profit their company has made or
67
Id. at 110
68 Id at 109.
69 E. Norman Veasey & Christine T. DiGugliemlo, What Happened in Delaware Corporate Law
and Governance From 1992-2004? A Retrospective on Some Key Developments, 153 U. PA. L.
REV. 1399, 1411 (2005) (citing a former Chief Justice of the Delaware Supreme Court).
19
how well the company is performing70
. As to a compensation evaluation, the pay ratio does not
tell the board the CEO’s productivity y, which can be checked whether the CEO hits the financial
and operational goals. The ratio does not compare the CEO’s pay to the market opportunity cost
v to see how much premium the company has paid and whether the CEO’s y entitles him to the
premium71
. Therefore the pay ratio does not offer substantial guidance to shareholders and the
board regarding investments and CEO’s compensation.
C. The Pay Ratio does not Necessarily Increase Employees’ Morale
Proponents of the compensation ratio rule claim that the rule will reduce CEO’s unduly
high compensation and bring some reasonable balance to a CEO and regular employees72
based
on the logic that sunlight eliminates unfairness73
. With embarrassment a compensation
committee is pressured to cut CEO’s pay. However embarrassment and media attention do not
necessarily lead to a board action though the ratio may have some positive effect on the
70
Financial ratios indicate the performance of a company. See p. 13.
71 See p. 8.
72 Cotton, supra note , at 178.
73 See generally Louis D. Brandeis, Other People’s Money and How Bankers Use it 92, 101-102
(1914)(claiming “sunlight is said to be the best of disinfectants . . . and publicity has already
played an important part in the struggle against the Money Trust” and believing the investors
will strike the unreasonably high commissions if bankers disclose them).
20
company’s consciousness of the pay gap74
. Thus “[d]isclosure itself doesn’t necessarily restrain
executive pay”75
.
Moreover, there are other ways to decrease the pay ratio without actually hurting a
CEO’s compensation. First, a CEO can increase the median person’s pay and at the same time
squeeze out juice from the below median employees as long as their compensations are above
the legal minimum. Dodging media critics, this action does not make workers at the bottom feel
any better and worsens the morale76
. Second, a CEO can increase workers’ compensation but
trim down their training expenses. This method is not of the company’s best interest because it
risks lowering employees’ productivity. In a long run, the redistribution of labor expense to
salaries does not boost the company’s morale because its employees cannot compete with well-
trained workers from comparable companies.
D. The Pay Ratio Unduly Influences CEO’s Operational Decisions and May Cause
Novel Opaque Pay Methods
74
See Stabile, supra note 49, at 163 (stating that “it is unlikely that merely disclosing
compensation ratios will lead to some action that will create a more reasonable relationship
between the pay of executives and rank and file workers.”).
75 Accounting Professor: Transparency Won’t Necessarily Control CEO Pay, Temple. U. News
Center, (Oct. 17, 2007) http://news.temple.edu/news/accounting-professor-transparency-
won%E2%80%99t-necessarily-control-ceo-pay (citing Professor Steven Balsam).
76 Cf. Cotton, supra note , at 181.
21
The pay ratio exaggerates unfairness of the CEO’s compensation without allowing
necessary adjustments for employee coverage77
. The rigid rule may invoke two responses from
CEOs, which are changes of the labor structure and creation of novel compensation methods.
First, some companies will be incentivized to outsource poorly paid jobs to increase the median
payment number. The flip side is the increase of administrative cost and losses of profits
generated by the to-be-outsourced department. Or companies will reduce workforce in their
foreign subsidiaries where the labor cost is relatively low. But obviously this reduction
sacrifices the low labor cost advantage. Therefore the proposal does not motivate CEOs to
maximize companies’ interests.
Second, executives may create some opaque and novel compensation method that is not
under the “total compensation” radar78
. The SEC proposed a flexible approach to compute a
CEO’s and the median person’s compensation, such as using tax records or payrolls79
. In this
situation, executives can recommend boards of directors to pay them benefits in a novel way that
the benefits are included in their payrolls or tax records. The disclosure will be “a continuing
race between the regulators, on the one hand, and corporate executives and their compensation
consultants, on the other80
.”
77
The SEC, supra note 1, at 36 (stating that the SEC disallows such adjustments due to high costs
though it admits some adjustments avoid distortion of the pay gap).
78 David I. Walker, The Manager’s Share, 47 Wm. & Mary L. Rev. 587, 656-57 (2005)
79 The SEC, supra note 1, at 117.
80 Walker, supra note, at 656.
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E. Assuming the Pay Ratio Disclosure Does Make the Board Cut a CEO’s
Compensation, the Pay Cut is not Always Good for the Company and Shareholders
i) Promoting Social Equality is not a Shareholder’s Primary Purpose
CEO compensation reduction may make the society appear more equal by narrowing the
pay gap of different talents in various professions. CEO’s pay is directly involved in the growing
disparity of incomes within the top twenty percent81
. The generous executive compensation
attracts people who have talents for other occupation to the already competitive CEO market,
and therefore make people less happy and less successful than they would have become had they
not choose the CEO path82
. Even if the lowered compensation rate releases people to utilize their
talents better, shareholders care more about a company’s profits than social equality83
. Investors
would not incorporate social governance issue into their investment decision84
because no clear
authoritative research reflects that the market incorporates workers’ satisfaction fully into stock
valuations85
. The SEC acts out of the delegated authority of protecting investors by advocating
for other stakeholders, such as employees and other professionals.
81
Charles M. Yablon, Bonus Questions- Executive Compensation in the Era of Pay for
Performance, 75 Notre Dame L. Rev. 271, 302 (1999).
82 Id.
83 See Veasay & DiGuglimlo, supra note 69, at 1411 (stating the shareholders focus on the firm’s
performance and profits).
84 The SEC, supra note 1, 97.
85 See A. Edmans, Does the stock market fully value intangibles? Employee satisfaction and
equity prices, J. FINANCIAL ECONOMICS 101, 621-640 (2011).
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ii) The Pay Ratio May Reduce the Number of Certain Compensation Litigations
Compensation litigation arises from primarily shareholders’ claim for breach of
fiduciary duties for corporation waste. A low pay ratio lends some credence to show the
compensation is not unreasonably high. For example, if UnitedHealth Group compensation
committee had looked at the pay ratio number during Dr. McGuire’s administration, it might
have concluded CEO Dr. McGuire’s backdate stock options were too much and reduced the pay
to avoid shareholders’ lawsuit86
. A board of directors or its compensation committee obtains a
direct view of the fairness of the CEO’s compensation and may deny the oversized pay package
to forestall money-burning litigations. But the ratio cannot effectively prevent golden-parachute
or option-valuation related lawsuits87
.[the ratio may provide shareholders information to lobby
for changes in a company’s compensation structure (One for A P163)]
F. Calculation of the Pay Ratio Incurs High Cost and Discourages IPOs
A large number of registrants and law firms object to the proposal due to the foreseeable
huge costs that would be incurred by the proposal. The SEC estimates the direct costs to
calculate the ratio may include approximately 201 to 500 hours per year and $3 to $100 million
dollars88
. The number varies depending on the complexity of privacy data compliance and
86
After years of litigation, the federal court approved special litigation committee’s settlement.
The protracted lawsuit brought the plaintiffs' counsel attorney's fees in the amount of more than
$29 million which was paid by the company. In re UnitedHealth Grp. Inc. S'holder Derivative
Litig., 631 F. Supp. 2d 1151, 1154 (D. Minn. 2009).
87 See p.14.
88 The SEC, supra note 1, at 102.
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different payroll system processes89
. In addition, the disclosure of the median payment amount
may provide sophisticated competitors with a clue to infer a registrant’s cost structure and
therefore places the registrant in a disadvantaged position compared to non-registrant90
.
The competitive disadvantages raise the costs of raising capital through public trading
markets and thereafter discourage companies to go public. The additional monetary cost
obviously makes an initial public offering (“IPO”) less attractive mean to raise capital though the
negative impact might not constitute a fatal factor that would kill the IPO91
. However a CEO
would feel reluctant to list the company because of the threatening embarrassment of pay ratio
disclosure. Therefore the pay ratio exerts a negative effect on IPOs.
G. Net Profit/ CEO’s Compensation Ratio- An Alternative
89
See p. 5.
90 Id. at 104.
91 The author checked the number of IPOs from 1970 through 2004 and focused on the points
around the time when a SEC executive compensation disclosure rule came out. Compared to the
macroeconomic condition at those points, only the pass of Sarbanes-Oxley Act in July 2002 had
a chilly effect on the number of companies going public though the S&P rose during that period.
It is not clear the declines of the number of IPO at the following time points were caused by the
roll-out of disclosure rules or glooming economic environment, December 1978, September
1983, October 1992, and November 1993. See Jay R. Ritter, Initial Public Offerings: Updated
Statistics, Table 8, (Nov. 15, 2013) http://bear.warrington.ufl.edu/ritter/IPOs2012Statistics.pdf;
and S&P Index (1960-Present Weekly), http://stockcharts.com/freecharts/historical/spx1960.html.
25
It is uncertain that the pay ratio will bring shareholders any benefit while it will cause
high cost and impose negative impacts on the corporation control. It has been shown that the pay
ratio does not seem a promising way to solve CEO’s overcompensation. But the failure of the
pay ratio does not implicate non-disclosure or a total free market. Without regulatory restraints,
CEOs would increase their compensations crazily in this one-side game in spite of the weak
compensation committee92
. So far the distorted CEO market cannot cure the CEO
overcompensation reality by itself93
.
I propose to use net income/ CEO compensation ratio instead of the pay ratio to evaluate
whether a CEO is overcompensated or not. The smaller the ratio is, the larger share of profits the
CEO receives. First shareholders and the board of directors may take this ratio seriously because
it indicates whether the CEO takes a large proportion of profits from the shareholders and how
well the CEO manages the company. The alternative ratio links the company’s performance, the
CEO’s productivity y, and CEO’s pay together. According to the survey mentioned in Part II
section C, the net profit/ CEO compensation ratio should at least exceed 1.66794
. By comparing a
company’s net income/ CEO compensation ratio with another company’s ratio, the board can
have a good sense of whether it gives this CEO a large β. Also the board shall have a direct view
92
Thomas, supra note , at 1175. Cf. Joy Sabino Mullane, Perfect Storms: Congressional
Regulation of Executive Compensation, 57 Vill. L. Rev. 589, 591 (2012) (alleging that any
executive compensation disclosure regulation has correlated to economic turmoil, rising
unemployment, and an executive pay controversy and the resulting legislation is a serious flaw).
93 See p. 10 & 12.
94 See fn. 35.
26
on how the profit distribution has changed through a vertical comparison of the ratios of the
same CEO during different time periods.
Second, my proposed ratio does not incur any additional calculation cost but can still make
employees feel happy and fair. A registrar does not have to devote any extra money to compute
the net income/ CEO compensation ratio because it computes the two numbers even without the
new rule95
. If the ratio increases and the profits grow, shareholders and employees will both be
happy about the good company performance despite of the large number of the CEO
compensation. Shareholders can expect big dividends and employee large bonuses from the
growing profits.
Third, the net profit/CEO compensation ratio creates an upward momentum to push
CEOs to compete with other CEOs to drive up the ratio. In contrast, the pay ratio put out a
CEO’s passion to work for the company because it threatens the CEO’s pay no matter how large
profits the CEO leads employees to make.
Conclusion
The SEC proposed the pay ratio disclosure rule which is designed to resolve the CEO’s
overcompensation issue. Hiring a CEO is almost the second important decision of the board after
a merger and acquisition decision. The majority believes CEOs are generally overpaid because
boards of directors are captured by CEOs. The Congress and SEC hope the unreasonable pay
95
Every registered company must calculate its annual net income in preparation for the basic
financial statements and the total CEO compensation is a required item on the company’s
summary compensation table. See p. 13 & 3.
27
ratio of CEO and median employees will embarrass boards of directors and make them cut CEOs’
pay checks.
However the pay ratio does not provide material information to investors and boards of
directors regarding the relationship between a company’s performance and a CEO’s
compensation. A CEO may create other ways to shrink the pay ratio without actually reducing
his own compensation. The pay ratio may promote social equality and reduce certain types of
compensation litigations but at the expense of CEOs’ wise operational decisions and high capital
costs. Due to the overcompensation reality and the undesirable pay ratio, the author propose net
profit/CEO compensation ratio as an alternative item to be disclosed by registrars. The
alternative ratio provides reasonable valuation of the CEO pay and his productivity while avoids
the high calculation cost. The SEC should adopt the net profit/CEO compensation disclosure rule
to offer shareholders useful information that enables them make informed investment decisions.